The Taming of the Skew

By

Kopin Tan

Updated Nov. 22, 2004 12:01 a.m. ET

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FOR MUCH OF THE YEAR, OPTION traders have had to evaluate a steady procession of stock-market worries: rising interest rates, high oil prices, election anxiety. But last week, as the Standard & Poor's 500 stock index soared to a 2004 high, and as thoughts turn to year-end bonuses and performance reviews, they caught a whiff of a different kind of fear -- the fear of missing a big rally.

It took a while to pick up this new scent, since stock benchmarks had traded for so long in a range so narrow it rendered this type of fear almost unfamiliar. But there it was, evident in what you might call the taming of the skew. The "skew" measures demand for out-of-the-money S&P puts relative to calls and has been elevated all year. But last week, it continued one of the sharpest declines in recent years as investors bid up index calls, with the S&P 500 up 7% in four weeks.

"The market is looking for leveraged exposure to the upside; there is limited fear of the downside," notes Mika Toikka, Credit Suisse First Boston's global head of equity derivative strategy. "If the current rally continues, we anticipate pressures to mount for performance chasing into year end."

There were other signs, too. The rate of call buying increased this month at the International Securities Exchange; on Monday and Tuesday, investors bought more than two new calls for every new put, near the most eager pace in seven months. Overall option volume topped 7.4 million Wednesday, the second busiest day ever, and the number of outstanding positions set new records.

As Toikka points out, there are reasons to be optimistic, with signs of economic growth, oil prices off recent peaks, and stable long-term interest rates. But with more investors counting these same blessings, how much of the good cheer is already priced in?

Advisers dutifully urged clients to guard stock gains, seizing the opening provided by Thanksgiving to cloak risk management in the autumnal hue of harvest. "If you've been riding the wave from the October lows, consider locking in profits by selling stock and substituting with a three-month, at-the-money call," reminded Ryan Beck option strategist Elliot Spar. Others screened for stocks that have run up, whose valuations are a source of concern and whose option premiums are low. Buying cheap puts shield these stocks if shares were to pull back, but do not cap gains if shares keep rising.

There were no shortage of option-hedging candidates, with many stocks trading near year highs. Susquehanna Financial Group strategist Robert Wilson picked as an example
American Eagle Outfitters,
which reported sound quarterly profits this month and which the firm is still bullish about. But the stock had rallied 152% this year -- a run-up large enough to tempt some to take profits before the holiday shopping season peaks. With shares at 41.29 Friday, cautious stockholders might buy December 40 puts for downside insurance; those looking to limit out-of-pocket expense might even sell December 45 calls to finance these puts, if they are prepared to sell shares at 45 before mid-December.

A warning from
Google
of slowing revenue growth spurred more trading. Investors who see a short-term stock-price cap -- whether due to slower growth, competition from
Microsoft,
or the release of more shares into the market as certain lock-up periods expire -- looked to sell calls. Because Google shares are volatile, call sellers can earn a hefty premium for committing to sell shares beyond certain targets; but the option selling proceeded cautiously, since Google has been known to surge despite market skepticism. With shares at 169.40 Friday, Google's December 180 calls were trading near $6.80, and the December 200 calls were going for $2.70.

Another stock trading near its year high is
Altria,
boosted by recent plans to one day split itself into different units. Uncertainty over the breakup has kept option premiums pumped. Because the split isn't expected to occur before Altria resolves its legal disputes, which could take at least a few months, some traders see a short-term cap on the stock price -- and a chance to sell calls to monetize the limited stock upside. Others smell an opportunity to sell puts, since the prospect of the split and the proverbial unlocking of value could set a floor for the stock price. Until the smoke clears, traders see something for everyone and option volume has been robust. With shares up 20% this month and trading near 58.05, Altria's January 60 calls, for instance, were trading near $1.80 and the January 55 puts were about $1.90.

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